Feasting On Low-Hanging Fruit: Constructing A Portfolio Of Distressed Equities With Optionality And Upside

|
Includes: BHC, CROX, FCX, FTR, JCP, LUB, M, RAD, STON, ZMTP
by: Michael W Byrne

Summary

With the market at all-time highs and trades in the top names getting 'crowded' it could be time to search for some bottom-dwellers with upside potential.

We discuss 'optionality' and why this is a key aspect of investing.

Optionality is an important component of what gives beaten down stocks upside potential.

Sentiment surrounding these stocks has been so negative and losses have been so severe that the bar is now set very low and impressive gains can be made from low-hanging fruit.

We construct a portfolio of 10 stocks that have plummeted in 2016-2017 and could be poised to take advantage of this low-hanging fruit and reward patient, risk-tolerant new investors.

The last few years have certainly been kind to equity investors, as stocks have continually made new all-time highs. Everyone talks about the ubiquitous FANG stocks and the tremendous gains that they and their high-flying peers have enjoyed. But with so much already gained in these names, I speculate that it’s time to go against the grain, take the road less traveled, and start exploring the dark depths of the equity market for stocks that have not only failed to join in on the good times, but sank to even lower lows despite the epic bull market.

The nice thing about investing in some of these beaten down stocks is that you can get some pretty attractive gains on even slight good news, because the bar is set so low. For example, look at Valeant (VRX), one of the most hated stocks on Wall Street, went up about 30% over the past week. Staples (SPLS) is hardly the sexiest name out there these days, to say the least, but shares of the beleaguered office supply retailer are up almost 10% today on buyout rumors (and even more over the past several days). Shares of distressed Canadian lender Home Capital (HCG.Canada) just rose about 30% based on Warren Buffett taking a stake in the company and throwing it a much-needed 2.4 billion Canadian dollar lifeline of credit. (Check out an interesting podcast about the Home Capital deal by Seeking Alpha’s Chris Demuth here) A further example would be Rite Aid (RAD) rising about 25% in a single day this week on rumors that its long-awaited merger with Walgreens (WBA) would finally be approved. Sure, I am cherry-picking examples here, and of course it can be dangerous to catch a falling knife, but keep in mind, these huge moves have all come over the past week or so, so there is plenty of opportunity out there for investors with a high risk tolerance to capture upside in out of favor names. As they say, fortune favors the bold, so let’s wade out into some treacherous waters here.

Of course, trawling the bottom like this for bargains with some upside potential is of little solace to investors who have already lost money on these names, and I certainly feel the pain of our fellow investors who have suffered big losses due to some of these laggards. However, investors with money on the sidelines looking for places to park some new, speculative money made from profits after the broader market has surged to all-time highs over the past year, it could be an enjoyable and fruitful strategy. What I really like about these types of beleaguered stocks is that they give you an incredible amount of optionality. Optionality is really the key to me, and one of the best facets an investment can have. By optionality, I mean that you have a wide array of possible scenarios and outcomes that will allow you to profit and come out on top; there is a lot of ‘flexibility’ so to speak. For example, here are a few of the potential outcomes that could benefit shareholders of a bottom-dwelling stock.

  • Due to the diminished market cap and valuation, the company could easily be taken over by a larger, more successful rival, at which point you would receive some sort of premium for your shares when it is acquired.
  • Or, the company could be taken private by a PE firm or other vehicle which believes it can fix the company outside of Wall Street’s prying eyes, at which point you would also most likely receive a premium for your shares.
  • You could also benefit from an activist investor stepping into the stock and pushing management to make the right changes that will help the company get back to better days.
  • Similarly, the CEO could be fired or resign on his or her own, and a new CEO can come in and make the right moves (Look at long-dormant shares of GE rising 3-4% the day that Jeff Immelt announced he was stepping down as GE’s CEO.
  • Of course you can also benefit from the company actually turning things around on its own and improving results and getting a fresh look from investors as its shares climb back up from its deepest depths.

To make an analogy, it's like a poker player having a lot of different outs for a hand in Texas Hold’ Em, or an NBA team building up a treasure trove of draft picks, long shots on cheap contracts and other projects with high-potential so that at a later date they can either grow into a great team, or use them in a trade to swing for the fences and get some bigger stars.

So, with that discussion of optionality and why I think that now could be an interesting time to trawl for some beleaguered names, let’s take a look at some of the companies that we could add to a speculative, high-risk/high-reward portfolio of distressed names. One final note of caution here before delving into the names is that while I’ve gone over plenty of good scenarios that could happen to the companies, of course the downside is that they could go out of business, go bankrupt, or suffer even further losses, which is usually a big part of the reason for their dramatic losses to date so far. But, by diversifying the portfolio and spreading the risk out over a wide array of names, I feel that we can protect ourselves from any one company tanking the whole portfolio. Furthermore, since a lot of these stocks are down 50-75% or even more from recent highs or even just YTD, I feel like a decent amount of the risk has been taken out as I am willing to take the chance that the damage is already done. You could even say that investing in these types of companies now, after such steep losses, is less risky than investing in some of the high-flying stocks out there where tremendous gains have already been made and there is more risk to the downside. To keep things simple, I’m going to say that we are investing an equal $10,000 into each of these 10 stocks and track it from there.

The Portfolio

Crocs (CROX)

At the risk of exposing myself as probably not the most fashion-savvy member of this website, I’m still a big fan of Crocs and enjoy wearing them around the house or for short errands (often to the chagrin of whoever I’m traveling with). But comfort and style (or lack thereof) aside, the stock itself is an interesting proposition. Shares have rallied 12% YTD, but are still down about 30% over a 1-year period and have fallen a long way further than that since its all-time highs earlier this decade. Well-known contrarian investor Alan Lancz told Barron’s this past weekend that he views Crocs as a ‘Speculative play with good turnaround potential’ which is really what all of these investments are about, at their core. While the shoes (sandals?) may not be as popular or trendy as they were during their glory days, they are still a popular choice for comfortable yet functional footwear for workers such as chefs and nurses, as well as for people just relaxing at home or even the beach.

The stock has already shown the ability to rally, surging 23% in early May before the rally fizzled out and shares fell back down again. In another Barron’s article, Jack Willoughby profiled the stock in a positive light, positing that “Investors and analysts should renew their faith in a company that, unlike Foot Locker, has already gone through a painful restructuring. The stock, which has lost 90% of its value since mid-2007, now costs about 20% of what you’d pay online for a pair of its “classic” clogs for kids. That’s an excellent deal, as the Colorado-based company climbs back to profitability and finds a better fit in an increasingly competitive marketplace.” Willoughby goes on to describe how the company is cutting costs and becoming more disciplined, with private equity powerhouse Blackstone (BX) taking a seat on the board and instilling more capital discipline. He speaks with Royal Capital Management co-founder Robert Medway, who has an $11 price target on the stock, which would give us a more than suitable increase for our portfolio. If the stock is good enough for Jamie Dimon to bet big on, it’s good enough for me.

Stonemor Partners L.P. (STON)

It doesn’t get much less sexy or exciting than a stock that operates graveyards and funeral homes. Perhaps the only thing spookier and more macabre than the death care industry that Stonemor operates in is the downright scary 62% decline its shares have taken over the past year. That’s a ride scarier than any haunted Halloween hayride. Ok that’s enough with the bad puns. Why should we be interested in Stonemor? Much like Frontier, Stonemor is another company that cut its dividend but still yields an incredible 14%. Seeking Alpha contributor Gideon Value wrote an excellent Pro article on why Stonemor can turn things around and start benefitting its shareholders again which breaks things down far more succinctly than I ever could, and believes the stock could reward shareholders with gains of 50 to 100% over the next year. With shares already trading at such beaten down levels, I like the upside versus downside scenario here. Causes for optimism include the fact that the CEO who presided over the decline stepped down in March and a new CEO is at the helm, so the company recognizes that change is needed, and the fact that insiders and executives have been buying shares. Read more about what is going on at Stonemor in this great recent article by always-entertaining Seeking Alpha contributor ‘The Knife Catcher.’ On a more macro level, and getting more speculative, there are only a handful of publicly traded companies in the funeral home/death care space, as the industry is still dominated by smaller, privately held and family-owned players, but as many second and third generation members of these families look to exit the business, Stonemor and its peers have plenty of potential growth ahead of them by gobbling up these assets. For example, according to a recent article in the Atlantic…

“Today, the overall industry is thriving—it takes in about $16 billion per year, according to the latest data from the National Funeral Directors Association But the model has changed: Chains and corporations have swallowed up much of the business. Since the 1990s, the largest chain—Service Corporation International, along with its Dignity Memorial products—has bought up competitors and small businesses to amass more than 1,500 funeral homes and more than 20,000 employees across North America, with $3 billion in revenues. The Houston-based SCI is often dubbed the Walmart of death-care, but it rarely passes along its cost-savings to consumers, instead charging more than many small companies, according to reporting from Bloomberg Businessweek.“

With the bar set so low and with risk to the upside seemingly outweighing risk to the downside here, plus demographic and company-specific factors seemingly turning in the company’s favor, I am confidently adding Stonemor to the portfolio.

Frontier Communications (FTR)

Trading at $8 a share as recent as two years ago, shares of this embattled communications company have fallen all the way to $1.16 at the time of writing. The company recently cut its dividend to $0.16 per year from $0.42, which was obviously not great for income investors but was probably a prudent move given the challenges facing the company. It can now use this additional cash to alleviate some of the debt weighing down on the company. Even with this big dividend cut, FTR is still paying out a hefty 13.8% dividend to shareholders. Of course, it’s possible this dividend could be cut again, but even if it is cut in half, the yield would still be pretty attractive. I’m fully aware that there are a lot of issues facing the company, that a lot of their customers and shareholders are disgruntled (including some of my family members) and that a turnaround will not be easy, but at just $1.17 I am more than happy to take a chance on FTR. I also like the fact that Frontier is heavily exposed to Florida and Texas, two states with growing economies and populations.

Luby’s Inc. (LUB)

The last few times I mentioned Luby’s to someone, they of course asked ‘whats’ that?’ And when I explained that it’s the company that owns restaurant chain Fuddruckers (as well as other brands such as Luby’s Cafeteria and Cheeseburger in Paradise), they uniformly were pleasantly surprised that Fuddruckers is still around. At time of press, shares were trading at $3.05, down starkly from the 52-week high of $5.07, and a far cry from prices the stock traded at before the recession. While I doubt it will ever hit those lofty highs again, it only needs to go up a fraction of that amount to provide new investors with a handsome return. Safety In Value wrote a comprehensive, well-thought out Pro thesis on Luby’s in April which I highly recommend reading, and Mark Krieger has also done a number of useful , informative, and entertaining write-ups on the company.

With a market cap of just $86 million, Luby’s could easily be acquired by any number of companies in the restaurant space, or a private equity investor. Furthermore, there is a high level of family ownership of the shares, so there is the possibility that the family could take the company private and pay at least some premium for the shares. Perhaps even more importantly than the prospect of a takeover or acquisition, the small $86 million market cap, according to Mark, is less than the value of the company’s real estate portfolio, which he estimates conservatively at $135 million. While perhaps a chain like its Luby’s Cafeteria brand may be seen as behind the times by some investors, getting the stock at a substantial discount to just the value of its real estate portfolio, with the possibility for other catalysts driving shares up, seems like a worthwhile wager to me. The stock has shown the ability to shoot up rapidly on good news before, surging from $2.46 at the end of May to $3.39 in early June, before settling back down to the current share price of $3.05 a share.

Macy’s (M)

Believe me, I dread shopping and going to stores as much as perhaps anyone you know, and you’re much more likely to find me golfing or even just sitting on a couch on the weekend than at a department store, so I fully understand the ‘death of retail’ story that has captivated the market and driven retail sector stocks to tremendous losses this year. That being said, we may be at the point where retail has become so hated that some of the stocks are at this point oversold. Shares of Macy’s are down nearly 50% from its 52-week highs and while there are certainly a lot of legitimate concerns about the challenges the company faces, and what it will do to differentiate itself enough to survive the age of Amazon, I like the iconic retailer here, trading at a P/E multiple of roughly 12x and sporting a dividend yield of north of 6%. While of course more and more shopping is migrating to online, it doesn’t mean that every single retail sale made will be through Amazon, and while some retailers will indeed sadly go out of business, it doesn’t mean every single one will, which is how the market has been reacting. Additionally, even with shopping shifting to online, that doesn’t mean Macy’s can’t get some of the online orders. Like Luby’s, the company also has a valuable real estate portfolio, which gives it plenty of flexibility and optionality in the future. In a recent research note following the company’s analyst day in June, Bank of America analysts Lorraine Hutchison and Heather Balsky note that the company is “staying nimble” in real estate, stating “Macys’ real estate monetization strategy remains on track. The company is working on monetizing flagship stores, is participating in an asset development alliance with Brookfield to garner incremental value from its owned/ground-leased, non-flagship store portfolio, and continuing to sell one-off assets… Management is staying nimble and creative with regards to the monetization of all of its assets. Examples include adding 10,000 square feet of small shop retail space in the front area of its Union Square San Francisco shop and potentially using the upper floors/roof of Herald Square for social/entertainment space.” They also state that they expect Macy’s to continue investing in its omnichannel strategy including its ‘Buy Online Pickup at Store’ strategy which is “one of the company’s most profitable initiatives.”

Macy’s has already bounced back about 10% off of its’ lows but is still so far down from its highs that it is a tempting addition here for value investors.

Valeant Pharmaceuticals (VRX)

Investors who owned Valeant back in the heady days of 2015 when it was trading at lofty prices in the $250 range are understandably upset with the company and it certainly has a questionable and controversial past, but as a new investor buying in at today’s price of around $17, the much maligned drug company could certainly be worth a flier. The stock traded at $8 a share within the past year, so has doubled since then, and is up a whopping 25% over just the past 5 days, so while it is down, it is certainly not out. The company has been paying down debt and well-respected hedge fund manager John Paulsen recently joined the board. While some may write this off and also point out that he has lost a lot of money on Valeant, he is a large shareholder and it stands to reason that he will push the company to do what is right for shareholders and will be motivated to help turn things around. The company knows it needs to improve its perception with investors and he has a large position in the company so it stands to reason that they will listen to him. Refer to this article by Seeking Alpha contributor Chris Lau for some other potential catalysts for the company. Author Andrew McElroy is also cautiously optimistic on the name and provides a nice technical analysis of it here. While it is a risky name and it has already bounced back more than many of the other names on this list, I am still interested in adding Valeant to our portfolio as it seems further out there is certainly still ample upside left for long term and risk-tolerant investors.

Freeport-McMoran (FCX)

I recently started building a position in mining giant Freeport-McMoran, which was part of what gave me the idea for this article. Plus, we’d be remiss to be writing an article about ‘diamonds in the rough’ without including an actual miner. Of course shares were trading below $5 in the dark days of early 2016, and have since doubled to over $11 (I started buying in in the high $10s and low $11 range), but they’re still well below their 52-week highs of $17.06. Carl Icahn, already one of the company’s largest shareholders, went even bigger on his bet by buying another 350,000 shares of the company earlier this month, just below current prices. While copper isn’t the most exciting commodity, Ed Lin of Barron’s points out that “Building construction is the single largest market for copper… Environmentalists should love copper, too. It is used in solar panels, and the Department of Energy is currently researching the use of copper to capture carbon dioxide emissions from coal-fired power plants,” and also describes how one of the other commodities FCX mines for, molybdenum, gives it leverage to a recovery in energy prices (“molybdenum-hardened steel is used in offshore oil exploration rigs and pipelines). I like the fact that the company is levered to quite a few different end markets and has plenty of optionality. Being more speculative, with housing prices surging over the last few years in large part due to a lack of supply and too much demand, at some point I assume there is going to have to be new housing construction, which will only further help FCX’s end markets.

Zoom Telephonics (OTCQB:ZMTP)

The smallest and most likely least-known name on this list will be Zoom Telephonics. Admittedly, this name isn’t down as much as some of the other names on this list, down just 33% since its recent highs last October, but given that decline and also the underfollowed nature of the stock (and the fact that its price is barely above the wild west ‘penny stock’ range), I feel that it fits in with this portfolio and is more than warranted for inclusion. The Massachusetts-based company “designs, produces, markets, sells, and supports Internet access and other communications-related products, including cable modems, cable modem/routers, mobile broadband modems, asymmetrical digital subscriber line (ADSL or commonly DSL) modems, and dial-up modems.” (Google Finance). I would never have heard of this company if not for the thorough research of Seneca Park Research, who wrote did an all-encompassing examination of the company for Seeking Alpha. He details the company’s 4 growth drivers; new geographies, new products, new distribution (such as Wal-Mart and Amazon), and new customers, and puts a $4-8 price target on the stock believing that it could be an accretive acquisition for a larger company. They point out that even if not as much interest materializes and the company is motivated to sell, it could still fetch $3 a share (perhaps given the CEO/founders’ age), which would give us a nice return of 33% on shares purchased today. As a word of warning, the shares of ZMTP are fairly illiquid, but I am pretty patient with this portfolio and am not looking to trade in and out of the shares so I’m not overly concerned about the illiquidity.

Rite Aid Corporation (RAD)

Of course shares of Rite Aid were up almost 25% on Monday as I started working on this article so the overall return on this call will not be as impressive, but let’s be honest, even with that massive one-day gain, shares of Rite Aid are still down 52% YTD and they, and their long-suffering shareholders, can use any help they can get. The shares are up on speculation that the FTC will finally approve RAD’s acquisition by Walgreen’s. With a stated acquisition price of $7 a share, even with this week’s bi g gains, if approved, that would still give the stock about 75% more upside. Even if the FTC doesn’t rule on it and delays its ruling, investors will just have to be patient and wait longer. And if for whatever reason the FTC doesn’t approve the move (With the seemingly laissez-faire approach of the current administration to business, I can’t see why the deal wouldn’t be approved in the current political climate), the stock would probably give up some of the recent gains in the short term, but would still be incredibly cheap and you could just wait for the company to improve on its own or be acquired by another company. For example, Seeking Alpha contributor Daniel Jones has written about the speculation that Amazon could buy Rite Aid. With a lot of downside already in the rearview mirror, and the potential massive near-term catalyst of the acquisition being approved, RAD seems like a perfect fit for our portfolio.

JC Penney (JCP)

Last but not least, we have JC Penney, a company whose long-suffering shareholders have suffered even more in 2017 so far. At one time, JC Penney was trading in the $80 range, and as recently as 2013 was still trading above $20 a share. Now, the shares are fetching a paltry $4.64. Investing in JC Penney is certainly fraught with risks, but at this point, I think it is worth a punt as part of a diversified portfolio like this. We discussed the challenges facing retail, and you’ve obviously heard about them ad nauseam over the past year or so from the media, so there’s no need to rehash them here, and JC Penney also has some debt concerns, but the company is also working to turn things around, working to cut debt and diversifying more into items like household appliances to differentiate itself from other clothing retailers. Seeking Alpha contributor Matthew Levy highlights “J.C. Penney added 60 additional Sephora locations in 2016 (bringing the total to 577) and plans to add another 70 in 2017. JCP installed 500 appliance showrooms in 2016, and it has provided strong results thus far. The company also continues to improve infrastructure and store improvements, helping results. Is it enough for a turnaround? I believe so.” I like the fact that they are adding appliance showrooms as this gives them some positive differentiation, and that they are adding more Sephora locations. Cosmetics seem to be a booming business right now, with stocks like Ulta Beauty going on a tear over the last few years, so it seems like a good area of the company for them to invest more in and expand. Levy concludes his research piece on Penney stating that “Management has done a tremendous job cutting costs thus far, and all internal indicators and projections seem to point to a sales improvement (for existing stores). J.C. Penney is making all of the right moves, and is set for a breakout with its unfactored potential and high (unwarranted) short interest.” Elephant Research does a really nice job of talking about how the low bar set for JC Penney and the potential for it to even slightly exceed it, could set the stock up for gains of up to $9-$10 in 2018-19, which is a good note to end this article on, as it really is what this entire portfolio is all about, exceeding low expectations to achieve outsized gains.

Conclusion

While this portfolio is certainly one with plenty of risk and danger involved, I believe that given the negative sentiment surrounding these companies and the drastic declines that they’ve already suffered means that there is much more risk to the upside than the downside. While I wouldn’t invest my life savings in any of these individual names, I think that diversifying and spreading the risk out over these 10 names gives us a margin of safety and find it likely that the majority of these names will provide a nice boost to the portfolio over medium to long term, even if a couple of the names decline further. I think that any name in this portfolio has the potential to surge on some good news or improving situations. I am hoping to provide a couple of updates on the performance of this portfolio over the next few quarters and am looking forward to seeing how it performs against the larger market. With the market at all-time highs, it’s a great time to trawl the bottom for companies that haven’t yet enjoyed the rally. In the words of Warren Buffet, “be fearful when others are greedy, and greedy when others are fearful.” I think it will be both fun/interesting and profitable to go against the grain here and take the road less traveled. I would love to hear from readers – what are your own ideas for other companies that you would include in a portfolio like this?

Disclosure: I am/we are long FCX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.